Reading 62

An analyst will use both qualitative and quantitative factors when evaluating the likelihood and impact of default by a corporate bond issuer.

Qualitative Factors

Qualitative factors include an issuer's business model, the degree of competition in its industry, its business risk, and the quality of its corporate governance.

• Business model. A high-credit-quality issuer has a business model with stable and predictable cash flows. For longer-term debt issues, the analyst should also consider any long-term changes the issuer must make to remain competitive — changes in the business model raise business risk.
• Industry competition. Less intensive competition is favorable for credit quality. Analysts must consider any change in the competitive landscape over the long term.
• Business risk. High-credit-quality issuers have low risk of unexpected deviations from expected revenues and margins. Business risk can originate from issuer-specific, industry-specific, or external sources.
• Corporate governance. Adequate processes for fair and legal treatment of debtholders are required. Specific concerns include debt covenants and accounting policies.

Within corporate governance, two specific areas matter:

• Covenants. Unsecured investment-grade issuers tend to have primarily affirmative covenants (compliance with rules and laws, asset maintenance, paying taxes). Analysts assess whether management could issue additional debt that dilutes existing debtholders' claims. High-yield issuers tend to also have negative covenants restricting dividend payments or further debt issuance. For high-yield, look for past management actions favoring equity investors over debt investors (e.g., a debt-financed stock buyback that triggered a downgrade).
• Accounting policies. Beyond outright fraud, watch for aggressive policies that accelerate revenue recognition, heavy off-balance-sheet financing, a strong preference for capitalizing rather than expensing, or frequent changes in auditors / CFO. These signal that management's character may impair creditworthiness.

Quantitative Factors

Quantitative modeling involves projecting future financial statements and cash flows to identify the key drivers of probability of default and loss given default, and how each is likely to behave over the economic cycle. Investors in unsecured investment-grade debt are mainly concerned with probability of default; investors in secured high-yield debt also care about loss given default, because high-yield default probability is higher.

Quantitative analysis can be performed top-down, bottom-up, or as a hybrid:

• Top-down inputs: the macroeconomic cycle, industry size and potential market share, and event risk from external shocks.
• Bottom-up inputs: issuer-specific drivers of revenue, costs, balance-sheet assets and liabilities, and future cash flows.
• Hybrid: considers both top-down and bottom-up factors together.

All else equal, an issuer is deemed to have higher credit quality when it has:

• Strong operating profits and recurring revenues
• Low leverage and less reliance on debt in the capital structure
• High coverage of debt service payments by periodic income
• High levels of liquidity to meet short-term debt obligations

Credit analysts compute ratios to assess creditworthiness, identify trends over time, and benchmark against industry averages and peers. The most common categories are profitability, coverage, and leverage.

Key cash-flow terms used in these ratios:

• EBITDA = operating income + depreciation + amortization. Drawback: it ignores capex and changes in working capital, which are necessary uses of cash for a going concern. Cash needed for these uses is not available to debtholders.
• CFO (Cash Flow from Operations) = net income + noncash charges − increase in working capital. Disclosed on the cash flow statement.
• FFO (Funds from Operations) = net income from continuing operations + depreciation + amortization + deferred taxes + noncash items. Similar to CFO but excludes changes in working capital.
• FCF (Free Cash Flow) = CFO − fixed asset expenditures + net interest expense. Discretionary cash that could be paid to providers of financing after all obligations are met.
• RCF (Retained Cash Flow) = operating cash flow − dividends. The "operating cash" can be CFO, FFO, or another preferred measure.

Each different bond of a particular issuer is ranked according to a priority of claims in the event of default. A bond's position in this priority is its seniority ranking.

Debt is either secured or unsecured:

• Secured debt is backed by collateral, which can be sold to recover funds for bondholders in the event of default. It can be further classified as first lien / first mortgage (a specific asset or property pledged), senior secured (second lien), or junior secured.
• Unsecured debt is a general claim on the issuer's assets and cash flows, divided into senior unsecured, senior subordinated, subordinated, and junior subordinated.

The general ranking of repayment priority is:

1. First lien / first mortgage
2. Senior secured (second lien)
3. Junior secured
4. Senior unsecured
5. Senior subordinated
6. Subordinated
7. Junior subordinated

All debt within the same category ranks pari passu — equal priority of claims. For instance, all senior secured debtholders are treated alike in bankruptcy. Any senior secured claims not met by the value of their collateral automatically rank pari passu with senior unsecured claims in the bankruptcy process.

Recovery rates are highest for the highest priority of claims and decrease with each lower rank. The lower the seniority, the higher the credit risk.

In default or reorganization, senior lenders have claims on assets before junior lenders and equity holders. However, a strict priority of claims is not always applied in practice. Lower-priority debtholders (and even equity investors) sometimes get paid even when senior debtholders are not paid in full, in order to accelerate the bankruptcy process. Bankruptcies can be costly and slow; during the process the value of a company's assets can deteriorate as customers and key employees leave and legal expenses mount.

Credit rating agencies rate both the issuer and the individual debt issues:

• Corporate family ratings (CFRs) / issuer credit ratings — typically based on the issuer's senior unsecured debt and reflect overall creditworthiness.
• Corporate credit ratings (CCRs) / issue-specific ratings — apply to a specific bond issue. Differences between an issuer's rating and the rating of an individual bond are driven primarily by seniority and covenants (including collateral).

Notching is the assignment of an individual issue rating that is higher or lower than the issuer rating. A common reason for notching is structural subordination: in a holding-company structure, a subsidiary's debt covenants may restrict transfers of cash or assets "upstream" to the parent until the subsidiary's debt is serviced. Even though the parent's bonds are not legally junior to the subsidiary's, they are effectively subordinated with respect to the subsidiary's cash flows.

Notching is less common for highly rated issuers than for lower-rated ones. When the overall credit rating is high, differences in expected recovery rates among individual bonds are less material, so the bonds may not be notched at all. For issuers with higher default probability (lower ratings), recovery differences matter more — so notching is more likely.